Okay, maybe financial planning isn’t as much fun as drinking egg nog, but, for entrepreneurs, it’s an essential practice that will yield far greater rewards.
Do You Really Need a Financial Plan for the New Year?
Does your company need to create a financial plan and build your 2013 budget right now. Regardless of your company stage or niche, the answer is yes. Absolutely. Your financial plan will provide you with a comprehensive financial picture of your company; it’s a map to get — and to keep — your business on-track.
Some entrepreneurs shoot for a five-year financial plan, but I think that’s too long. I recommend a three-year financial plan. A three-year plan also covers a long period of time (admittedly your financial outlook is bound to change during that time period), but it’s a good exercise, comprising your major company objectives, top milestones, key assumptions, trending analysis, key variables, and your timeline.
Your three-year financial model isn’t set in stone; it’s a working document. Every year you will need to perform this annual budgeting exercise, and I recommend updating your budget on a quarterly basis (at least). So this will only be the first of your forecasts for 2013.
Process for Creating Your Financial Plan
Creating a financial plan isn’t exactly a linear process, with a direct line from point A to point B. It’s more of an ongoing dialogue during which you will find yourself performing a balancing act. The process goes like this:
- Identify objectives. Go to stakeholders and members of executive team to find out what they need to achieve their objectives for the new year in terms of revenue, product, market, or overarching strategy.
- Programmatic cost analysis. Consider your model from a programmatic perspective, by looking at the necessary resources to achieve your objectives. Otherwise known as a cost outcome analysis, the point is to assess the resources and their associated costs.
- Tradeoff discussion. This cost analysis will lead you to a company discussion (possibly just among the executive team) to discuss the total amount required and how this measures up against your milestones. There may need to be some tradeoffs. In fact, this is more than likely!
- Bottom-up forecasting. This dialogue will become the foundation of a bottom-up forecast in which you will project your company revenue growth over the next one to three years, and calculate the spending necessary to achieve your desired revenue/development, including headcount projections, professional services, and capital spending.
(Note that you will likely need to do a top-down projection as well, if you are fundraising; VCs want to see a big potential market and revenue in every venture opportunity. But, a top-down projection — which starts with market size from which you extrapolate to calculate your total potential revenue — is just a bogus projection, not very useful for your purposes.)
Converting Your Financial Plan into Your Annual Budget
Now that you have your bottom-up forecast, you’re ready to build your 2013 budget. Here’s how:
- Budget on an accrual basis. GAAP (Generally Accepted Accounting Principles) require that your financial information be reported on a full accrual basis. In other words, you need to report your revenue as it is earned, rather than reporting when cash is paid. The difference between cash and accrual is around capital expenditures. To create a full accrual budget, you will need to estimate projected money in and out over a given period.
- Report budget by department and major cost drivers. Identify your true cost drivers and break down your budget into expense categories and revenue categories.
- Plan actions. Once you’ve broken down your budget, assess how quickly this will impact your revenue. Also consider what you will be able to achieve based on spending.
- Identify key variable costs. This is the cost to make your products or provide your service (depending on your business). These costs could include materials costs and/or consultant salaries. Track these costs regularly to keep an eye on profit margins.
- Identify and test key revenue assumptions. Your budget is built upon assumptions rather than precise numbers. So it’s essential that you identify your key revenue assumptions and test them to validate and/or adjust your forecasting. Your key assumptions need to be easily adjusted so that you can run different scenarios to see what is working — or not — and make changes accordingly.
The best gift you can give to your business is to create a solid financial plan and set your annual budget. These financial activities will help you to take stock of where you are and what you have achieved this year — and to recalibrate for the upcoming year. Merry Financial Planning and Happy New Budget!